Large or small, any builder taking on a new job wants to know how much profit they expect to make on that job.
Throughout the job, contractors want to know how they are progressing and whether or not expected profit levels are likely to be achieved. Beyond individual jobs, they need to know how they are tracking over their entire business and whether or not they are on track to make sufficient amounts of gross profit in order to cover overhead costs and deliver the overall levels of net profit which they expected over the course of the year.
One important tool that can help with this is known as a work-in-progress (WIP) schedule - a tool which tracks the progress and financial performance of a project throughout its life cycle.
Essential components of the WIP schedule fall into two categories. First, there is basic contract information. As well as the job name and number, this includes the total contract value (including change orders), estimated costs (including change orders) and the estimated gross profit for the contract. This forms the baseline of expectations regarding overall level of revenue, cost and profits which are anticipated over the project’s life.
Second, there are actual totals at the point in time in question. This includes the percentage of the work which has been completed, the actual project costs to date, recognised revenues, gross profit, actual amounts billed and the amount which has been over or under billed. It is this information which is used to signify how the project is progressing in terms of delivering upon its revenue and profit expectations.
Essentially, the schedule has three uses:
- From an accounting viewpoint, it enables the easy calculation of an adjustment which is necessary at the end of each accounting period to convert information shown through transactions into an accurate representation of accounting profit earned on the project to-date.
- From a management viewpoint, it provides a clear and accurate picture about how (a) that individual project and (b) the business across its projects are tracking from a profit perspective.
- It also provides management with warning signals about potential problems which may be surfacing on the job and which may need investigation and/or action.
On the first point, basic accounting principles in Australia (and internationally, under international accounting standards) reflect that revenue associated with customer contracts is taken up in accordance with progress toward satisfying their obligations under that contract. In other words, if a construction project is 50 per cent complete, the amount of revenue recognised in the books at that point for accounting purposes should equate to exactly half of the overall revenue expected to be derived over the life of the project.
To achieve this, an adjustment has to be made at the end of each reporting period to reflect any amounts which have been either over- or underbilled. Over- or underbilling occurs where the proportion of revenue billed to the customer either exceeds or is less than the proportion of the work which is complete at that stage. For instance, in a half-finished project, a project would be overbilled/underbilled if say, 60 per cent or 40 per cent of the estimated revenue had been billed to the customer to-date. Where this happens, a WIP adjustment would be made either upward or downward within the accounting system to ensure that the total amount of revenue recognised on the project from an accounting perspective was equal to 50 per cent (the portion of work completed to-date) of the total contract value.
This adjustment is necessary to ensure that the financial accounts at the end of the reporting period reflect a true and accurate picture of the amount of profit earned on the project to-date from an accounting perspective. For companies who are required under the Corporations Act to prepare accounts which accord with accounting standards issued by the Australian Accounting Standards Board (typically those companies which are listed on the ASX or have a large shareholder base), this is mandatory in order to ensure that the accounts comply with AASB 15 (Customer Contracts). For any other businesses/companies who have to report on a periodic basis to external parties (financiers, investors and so on), using a WIP schedule in this way is not mandatory but is recommended as best accounting practice.
Beyond accounting, however, Philip Cadusch, ERP sales manager, ANZ at Viewpoint says, the power of a WIP schedule lies in its use as a management tool. Without WIP, Cadusch says contractors often understand how much profit they expect to make at the start of a project and what the results are anticipated to be at the end but have little idea during the project how they are going in terms of delivering upon those results.
By contrast, those who maintain a WIP schedule can ascertain at any time how the project is progressing from a profit perspective, whether or not profit and margin expectations are being achieved and if not, what action is needed. By summing data from the WIP schedules of all their projects together, moreover, they are able to ascertain how they are performing against expectations overall across their business from a gross profit perspective and whether or not they are on track to make sufficient levels of gross profit to adequately cover their overhead expenses and meet their target level of net profit. Where this is not the case, knowing this up front empowers them to take corrective action.
“A contractor who does not employ WIP analysis or complete WIP schedules is probably a contractor that does ‘cost complete’ or ‘end project forecasting,” Cadusch said. “What they would do is they look at their project and they try to understand what the results are going to be at the end of that project. They know their budgets, they know roughly where they are up to in terms of their commitments and costs and they know what they have left to go. So what they are doing is projecting out their end results.
“What a WIP schedule allows you to do at a project level is understand whether you are achieving those results on a month-by-month basis as opposed to getting close to the end and going ‘oh gee, we forecast this but there is no chance that we are going to arrive at that result.’
“A WIP schedule affords contractors the ability to validate those forecasts and gives them some reconciliation points between their forecasts and their revenue, costs and margins on a monthly basis. They can keep coming and validating – ‘this is what I said, this is what happened, this is what I said, this is what happened’ as opposed to getting to the end and saying ‘I thought it was going to be x, it is going to be x minus 500.’”
The third advantage of a WIP schedule is its ability to highlight any ‘red flags’ or indications that things may not be going as smoothly with the project from a financial perspective as expected. Where underbilling has occurred, for instance, Cadusch says the contractor is effectively financing the project from their own cashflow. Where this happens, he says it is important to understand what is going on and why this is happening. Of course, where underbilling has occurred, questions should be asked about whether the full amount of projected revenue for the project will in fact be recoverable.
On the flip side, where there has been overbilling, Cadusch says this is likely a positive but stresses again that it is important to understand why this is happening. In cases where the contractor has been able to ‘front-load’ billing and bill higher proportions of the project revenue at earlier stages of the project, then this may simply represent good cash-flow management.
Nevertheless, he says it is possible that the reason for overbilling is in fact not known. Potentially, this could signal that project forecasts may not have been accurate. The overbilling could also be delivering a misleadingly optimistic picture of how the project is actually performing from a profit perspective – a phenomenon which could reverse in later stages of the project whereby revenue from billings was proportionately less relative to the proportion of work performed.
In a similar manner, profit fade or spike (sudden surges or drops in project profitability in a singular month) could provide further signals that something is amiss. Courtesy of appropriate WIP adjustments at the end of each reporting period (typically, each month), revenues and profits should be taken up in the books in a ‘smooth’ fashion according to the percentage of the work which is complete. Any sudden movements upward or downward could therefore signal that there is something in the project which is not going on as expected.
Cadusch says the importance of understanding these movements should not be underestimated. He gives the example of a contractor who courtesy of front-loading their billing showed a positive cash position of $1 million early on only to find at the end of the project that they lost $100,000.
“Everyone at the start of that job would be going ‘isn’t this wonderful – we are up by a million dollars and we are forecasting this great profit,’” he said. “But unless you are looking at it, assessing it and understanding the spikes and the troughs and why these are what they are, you won’t have the confidence – or you shouldn’t have the confidence – that you are going to make a good profit on that job.
“Just getting money in the bank is no guarantee of success.”
When using a WIP schedule, Cadusch says it is important that its use is driven by the operations team more so than the finance team. He says a common misconception revolves around WIP as merely a finance tool. Primarily, he said, it is a tool for operational business and project management.
Indeed, since finance personnel are generally less involved than operational personnel with individual projects and thus have less visibility in regard to project progress, any WIP calculations which are made by the finance team without consultation with the project team risk being inaccurate. Rather, he says the operations team must be heavily involved in the use of WIP and any calculations performed.
Throughout the construction sector, use of the WIP function within software programs provides important insights about how projects are progressing from a profit perspective.
Those who use it will be rewarded with ongoing visibility into how their projects are performing and greater confidence about likely end results.